Tesco’s (LSE: TSCO) share price is down 3% from its 18 December 12-month traded high of £3.75. That said, the stock is still up 33% from its 13 February low of £2.72 over the same period.
So, is this a rare opportunity to buy Tesco shares on the dip or were they overvalued already?
How does the valuation look now?
My starting point in assessing a stock’s true worth is to look at its key valuations against its peers.
On the price-to-earnings ratio benchmark to begin with, Tesco currently trades at just 12.7 compared to its competitors’ 18.5 average. So, it is very undervalued on this basis.
Meanwhile, on the price-to-book ratio, it is overvalued, trading at 2.1 against a 1.5 peer average. And on the price-to-sales ratio, it is fairly valued at 0.3 – the same as the average of its competitors.
So, I ran a discounted cash flow analysis to get a clearer take on Tesco’s value. This shows the stock is 46% undervalued at its price of £3.63.
So technically, the fair value for the shares is £6.72.
They may go lower or higher than this, given market uncertainties. However, it confirms to me how much value remains in the stock.
Do recent results support this bullish view?
Tesco was a big winner over the Christmas period covering the six weeks to 4 January, according to industry figures.
Like-for-like (LFL) year-on-year sales rose 4.1% in the UK, 4.8% in the Republic of Ireland, and 4.7% in Central Europe. LFL sales measure a retail business’s growth from its existing stores and space, excluding new store openings or closures.
Over the Q3 period running to 23 November, LFL sales in these respective regions increased 3.9%, 4.4%, and 3.5%.
Given these numbers, Tesco reaffirmed its 2024/25 financial year retail adjusted operating profit forecast of “around £2.9bn”. In 2023/24, the figure was £2.76bn. It also maintains its forecast that it will generate £1.4bn-£1.8bn of retail free cash flow over the medium term.
Analysts forecast that its return on equity will be 16.9% by end-2027.
Will I buy the shares?
I am tempted by a 46% undervaluation in a growth stock. However, at my late point in the investment cycle (aged over 50), I am deterred by its short- and medium-term risks.
The main short-term one in my view is the impact of the October Budget’s 1.2% increase in employers’ National Insurance. CEO Ken Murphy said Tesco will face additional costs of about £250m a year from this.
The main medium-term risk is further similar tax increases. These would increase firms’ costs more widely, fuelling inflation and increasing the cost of living. This could see customers significantly cutting back on their supermarket spending.
On the other side of the returns equation, Tesco’s current 3.4% yield is much lower than the 7%+ return I demand from my dividend stocks. So, it is not for me on this basis either.
That said, if I were even 10 years younger, I would buy Tesco for its long-term prospects. I think it will remain a leader in the UK supermarket space, which should drive the share price (and yield) higher over time.
